McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Market Hypothesis 1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is efficient if prices “fully reflect” available information and adjust rapidly to new information.  In an efficient market, public information cannot be used to earn above-market returns after adjusting for risk. 2

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  In an efficient market, security prices fairly reflect all that is known by investors.  An efficient market is a “fair game” as long as information is equally available. 3

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If a market is efficient, price levels are not random; price changes are random (cannot be predicted). Why would price changes be random? ◦ Prices react to new information ◦ Information is new only if it is not expected 4

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1. Weak form 2. Semi-strong form 3. Strong form ◦ These vary with respect to the set of information 5

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A market is weak-form efficient if prices fully reflect market data. 6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Technical Analysis –using patterns in market data to predict price changes.  If the stock market is weak-form efficient, can technical analysis benefit investors? 7

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is semistrong efficient if prices fully reflect all public information. 8

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Fundamental Analysis –using economic and accounting information to evaluate a security.  If the stock market is semistrong form efficient, can fundamental analysis benefit investors? 9

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  A market is strong form efficient if prices fully reflect all information, public and private.  If the stock market is strong form efficient, do insiders have an advantage over other investors? 10

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are efficient (with respect to you): Diversify broadly Match portfolio risk to your risk tolerance Buy & hold 11

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. If you believe markets are inefficient: Try to beat the market by identifying undervalued securities or sectors & overweighting. 12

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  To interpret the evidence on EMH, we must distinguish between statistical significance and economic significance.  The key issue is whether or not investors can earn above-market rates of return without taking on above average risk. 13

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  The evidence is generally consistent with weak form efficiency in securities markets. Most studies conclude that technical analysis is not profitable. 14

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  The empirical evidence is generally consistent with semistrong efficiency: security prices tend to adjust very rapidly to new information. 15

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  While most evidence supports semistrong efficiency, several price patterns are inconsistent with semistrong efficiency (“anomalies”). 16

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  An “anomaly:” something that deviates from what is believed to be true.  Stock market anomalies: ◦ Small firm effect (Fig. 8.3, p. 241) ◦ Book-to-Market ratios (Fig. 8.4, p. 242) 17

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.  Risk Premiums or market inefficiencies?  Evidence of a past pattern of stock returns is not enough: is there any reason to believe the pattern will persist in the future? 18